Do Behind-the-Scenes Payments Hurt Investors?

ByIanthe Jeanne Dugan

November 7, 1999

An E-Trade marketing message assures, "Be not afraid, your order has been placed."

But that is precisely the moment when investors should be paying close attention. Once at E-Trade Group Inc. or any other stock brokerage, an order to buy or sell shares is shopped around before a trade is made. Theoretically, it fetches the best deal with the most speed.

But this "best execution" does not always happen. Securities and Exchange Commission Chairman Arthur Levitt Jr. said during a speech here Thursday that federal examiners recently reviewed how firms are executing trades and came up with many "troubling" preliminary findings.

"Some firms appear to be allowing payments for order flow or other inducements to affect which markets they send their orders to--at the expense of the quality of executions," said Levitt, speaking at the Securities Industry Association's annual meeting.

Levitt was shining light on a routine payment stockbrokers get for their orders by "market makers," the major firms that buy the shares investors want to sell and sell the shares investors want to buy. The message was the central part of a major speech on how brokers can best execute the orders of their customers, with speed, price and cohesive links among various new exchanges that have proliferated with new technology.

The speech was part of a broader push by Levitt to control the fairness of trading as technology creates new Wall Street competitors and individual investors go it alone. His comments complemented an earlier speech by Henry M. Paulson Jr., chief executive of Goldman Sachs Group Inc., who lamented that a severe lack of coordination among all the new markets was making it difficult to keep track of what is selling and for how much.

"There's a fine line between competition and chaos," Paulson said. "The lack of linkages between these new markets make it more difficult for brokers to find the best price for investors."

Charles Schwab & Co.'s co-chief executive, David S. Pottruck, called this "fragmentation" a myth, saying that building a central structure through which all orders should pass is unnecessary. "The fact is that our markets have never been more integrated than they are today--the best prices are accessible to all," Pottruck said.

But Levitt said investors are not aware of what happens to their orders once they are placed. When brokerages receive orders from individual investors, they quickly search around for the best matching bid and offer on that stock. Often, the huge buyers and sellers, in an effort to grab the deal, shell out extra money for the order.

Typically, these market makers pay half a cent per share to the broker who has an order for a heavily traded stock--those that trade in increments of one-sixteenth of a dollar, according to sources in the industry. They pay 1 1/2 cents for less-liquid stocks that trade in increments of one-eighth or at a wider spread that provides more potential to profit. The market makers then turn around and attempt to make more money on the stock by selling it for a slightly higher price or buying it for a slightly lower one.

"Few investors know about these behind-the-scenes arrangements that can cause them to pay too much when they buy a stock and get too little when they sell," said Bradney Skolnik, Indiana securities commissioner and president of the North American Securities Administrators Association.

This "payment for order flow" is not illegal. But Levitt questioned whether it motivates brokers to funnel orders to buyers and sellers that are paying them, rather than to those offering the best deal to investors, thereby creating a conflict between brokers and their customers.

"Payment for order flow is acceptable if the quality of execution is not sacrificed," Levitt said. "But it's becoming increasingly clear that's not always the case."

Several leading brokers say their decision about where to route an order is not swayed by this payment. "We only route it to the company that is paying for the order if it also provides the best execution for our customer," said Jack R. McDonnell, president and chief executive of Ameritrade Inc., one of the nation's biggest online brokers.

Whether an order will garner a special payment depends on the stock and the market maker. On average, Ameritrade earns less than $2 per trade from payments they receive for their order flow from market makers. "This offsets our operating costs and allows us to give our customers lower fees," McDonnell said.

Levitt said many brokers the SEC reviewed reported that speed was the most important factor in their order-routing decisions. If a stock is trading in increments of one-sixteenth, they rationalize, "what's the difference?"

Levitt answers it with a dramatic illustration. A broker who receives 1 cent a share for a 1,000-share order gives up the possibility of a one-sixteenth improvement in price somewhere else. Even if a broker passes along the rebate--"unheard of," according to Levitt--the customer has overpaid by $52.50. "To an investor," he said. "That's real money."

In 1995, the SEC began requiring disclosure of payment for order flow so that customers understood how a broker was making money. "More informed investors," Levitt reasoned, "apply competitive pressure to order flow arrangements, aligning the investor's interest with the broker-dealer's."

Much of today's disclosure, though, he said, while factually accurate, is unclear to investors. So investors are unaware there's a problem. Though trouble getting orders placed is small investors' biggest complaint to the SEC now, Levitt said, "they aren't aware of this price problem."

The problem is particularly acute, Levitt said, in the options markets. A new electronic market is being developed, spurring greater competition. An options contract once listed on a single exchange is now placed on a multiple listing, making it hard for an investor to tell what others are willing to buy and sell for.

The competition has brought down the price: Of 81 options recently examined by the SEC, Levitt said, the spreads--the price between what a market maker would buy the option and what they would sell it for--on 76 of them narrowed by more than 15 percent since August.

Levitt three weeks ago encouraged the options markets to link their systems and provide investors with the best execution, giving them 90 days to comply. He also is discouraging these budding businesses from creating payment for order-flow arrangements.

"What Levitt is calling for is so long overdue," said William Porter, the founder of E-Trade, whose latest brainchild--an electronic options market called the International Securities Exchange--is to be up and running in the spring.

Equally enamored was Matthew Andresen, president of Island ECN Inc., a New York-based electronic trading system that is seeking status as an independent stock exchange.

"If you place an order for 100 shares of Intel, you should know where your order is going and why," he said. "It's this big abyss. And people should be paying attention."